A Hellenic Haircut

There will be no Greek default—not for months to come at least, as we predicted here two weeks ago. The private banks that had splashed out on ostensibly lucrative Greek bonds will have to accept a “haircut” of fifty percent of their nominal value, according to an agreement reached early Thursday morning after days of tense talks between French President Nicolas Sarkozy, German Chancellor Angela Merkel, other euro zone leaders and private financial institutions.

Greece’s private-sector debt is now down to 100 billion euros, and the country will continue its long road to nowhere with zero growth, cuts and austerity. Even after the 50 percent write down its debt is still 90 percent of the country’s GDP and for as long as it stays in the euro the burden can never be paid off. To make the banks agree to the deal, however, the euro zone governments had to offer them inducements in the form of “credit enhancements”—bureaucratese for provision of low-cost government liquidity—worth over a third of the “haircut” itself.

More significantly perhaps, the European Financial Stability Facility (EFSF) will be boosted to €1tn ($1.4tn)—which may not be enough to preempt another crisis in a big southern economy, such as Italy or Spain. Merkel’s plan is to use the facility to provide insurance on new Italian and Spanish government bonds, but private investors are yet to be convinced that the fund will actually pay out in case of a large sovereign getting into trouble. If the insurance option is not embraced by private investors, the EFSF’s one trillion euros will be woefully insufficient to contain even the likely fallout from Grece’s half-default, let alone a major future crisis. This is the main weakness of the deal reached in Brussels. The European Financial Stability Fund needs to be expanded to be credible, and yet it cannot be done without issuing Eurobonds which the Germans unsurprisingly refuse to underwrite.

The elephant in the room is the euro itself. Back in 1990 the common currency was a French idea, the late François Mitterrand’s condition for his approval of Germany’s reunification. In theory it was supposed to remove exchange rate risks from the euro zone market, reduce the costs of transactions, stimulate cross-border trade, create an area of monetary stability, and force member countries to practice fiscal responsibility. The unstated intent was to curtail the power of the Deutschmark and to bind reunited Germany more closely to Europe. It was to be Chancellor Helmut Kohl’s burnt offering on the altar of European integration. In January 2002, colorful new banknotes and coins replaced national currencies in the initial 11 countries of the Eurozone.

In the early years the plan worked to the advantage of the periphery. All of a sudden, it was possible to obtain loans in Athens, Madrid or Dublin at interest rates as low as those in Berlin or Frankfurt. The result was a period of southern rapid growth—largely financed by northern capital in quest of fresh opportunities—and German stagnation. The “PIIGS” (Portugal, Ireland, Italy, Greece and Spain) used the cheap cash not to modernize their economies, however, or to increase their competitiveness, but to finance speculative projects and to indulge in excessive public and private consumption. Tens of billions went into building booms along the Spanish Costas and into Greek government bonds. Ireland’s growth reached 4.5 percent in 2004, fueled by a property boom but not accompanied by an improvement in its international competitiveness.

However seemingly disadvantageous for the Germans, the new situation proved to be a blessing in disguise for them. The periphery was awash in investment funds and it was temporarily oblivious to the fact that it could no longer defend its markets against future German imports through periodic devaluations. The Germans grasped the implications, however. The manufacturers realized that their only chance was to become ever more efficient and globally competitive. The workers had to endure years of flat wages and high unemployment. The fruits have been ample: since 2007 Germany’s export-led economy has continued growing in spite of the crisis. Its budget deficit will drop to zero in 2014 and likely move into the black thereafter.

A conspiracy theorist may argue that the Germans had known all along that the euro would create a captive market for their export juggernaut. The southern periphery could no longer protect its domestic markets from the deluge of better made, more efficiently produced German goods by resorting to occasional devaluations vis-à-vis the Deutschmark. The gap was bridged by northern commercial banks supplying loans for southern purchasers of mainly German goods. The southern periphery is now caught in a triple bind: its exports cannot grow because they cannot be boosted by devaluation, its domestic demand cannot be stimulated because they are forced to implement draconian austerity measures, and its economies are additionally burdened by high interest rates on German-led, multi-hundred-billion rescue packages.

By design or by default, Germany appears to have created a new European order which it dominates more effectively than she ever controlled the short-lived New European Order seven decades ago. The trouble is that the financial and political burden of the euro-project is becoming almost as steep for Germany as the price of running the global empire continues to be for the United States. Writing off a significant portion of southern debt, a la Greece’s “haircut,” creates a precedent that may create similar expectations in other, much larger troubled economies. The alternative is to continue making large net transfers and putting together ad-hoc rescue packages when crises erupt, but the will of the German political and financial establishments to continue doing so is wearing thin. The periodic crises will continue until the euro is taken apart, or until the four PIGS—and perhaps Italy, too—are expelled from the Eurozone.

Euro-enthusiasts predictably argue that without monetary union the exchange rates would fluctuate wildly and destroy the Union. In reality, trying to keep the euro zone afloat at any price is the biggest threat to the Union. For as long as the euro is upheld, the European Central Bank will be trying to square the circle of operating a single monetary policy and uniform interest rates for a widely different group of countries. The results will be periodical emergencies all along the periphery. They will take different forms at different times—a fiscal crisis here, a banking collapse there, a property slump everywhere—but like the erupting lava finding its way through the Earth’s crust, the crises will never stop and can never be resolved.

Only on the ruins of the Eurozone, or perhaps after it is reduced to its northern, hard-currency, inflation-free core, will it be possible to recreate a self-adjusting exchange rate mechanism reflecting different countries’ economic efficiencies and fiscal policies. Once it is accepted that the euro had always been a political project not justified by economic considerations, the ongoing drama would be finally over. Such outcome would benefit Europe and the rest of the world.